Learn about the simple model used to describe where money goes and what it is exchanged for in a market economy. The circular flow model of economic activity shows you the basic relationships between households, firms and the government.

Learn about the simple model used to describe where money goes and what it is exchanged for in a market economy. The circular flow model of economic activity shows you the basic relationships between households, firms and the government.

Circular Flow of Economic Activity

The circular flow of economic activity is a model showing the basic economic relationships within a market economy. It illustrates the balance between injections and leakages in our economy. Half of the model includes injections, and half of the model includes leakages. The circular flow model shows where money goes and what it's exchanged for. The model includes households, businesses and governments. We also have the banking system that facilitates the exchange of money and, as we'll see in a minute, helps to productively turn savings into investment in order to grow the economy. In the circular flow of the economy, money is used to purchase goods and services. Goods and services flow through the economy in one direction while money flows in the opposite direction.

The circular flow model shows the balance of economic injections and leakages

The factors of production include land, labor, capital and entrepreneurship. The prices that correspond to these factors of production are rent, wages and profit. People in households buy goods and services from businesses in an attempt to satisfy their unlimited needs and wants. Households also sell their labor, land and capital in exchange for income that they use to buy goods and services that firms produce. Businesses sell goods and services to households, earning revenue and generating profits. Businesses also pay wages, interest and profits to households in return for the use of their factors of production. Governments levy taxes on households and businesses in order to provide certain benefits to everyone.

Injections and Leakages

Let's talk about injections and leakages. When you look at the circular flow model more closely, you find that there are things that inject money into the economy and other things that leak out of the economy. Injections into the economy include investment, government purchases and exports while leakages include savings, taxes and imports.

Savings leaks out to borrowers as it goes through the banking system, and borrowers use the money to buy goods and services, which then injects the money back into the circular flow. Government taxes leak out of the circular flow model, and then government spending injects them back into the economy. Imports leak out of the economy because the money in our country that's used to buy imports from other countries goes out of our economy and into their hands. Exports, on the other hand, are an injection because we earn income from the goods and services we export to other countries.

Circular Flow Model in Action

The circular flow model involves businesses, workers, banks, and the government

Let's look at an example of this model in action, featuring Margie and Dave.

Margie trades her human capital, which is all of her knowledge, skills and abilities with a firm and earns an income at the same time. She then takes her income and deposits some of it in her bank checking account, which she'll use to buy goods and services from firms. Margie deposits the rest of her income into a savings account at the bank. Well, the bank is going to take her savings and loan out most of it (let's say about 90%) to Dave, who's an entrepreneur. Dave borrows this money to invest into the economy. Both Margie and Dave will pay taxes to the government - Margie probably paid some of her taxes already but may owe more at tax time. Dave's investment will generate a profit, and he'll have to pay taxes to the government as well. The government collects taxes from Margie, Dave and even the banks. They spend some of it to buy fighter jets, so they can protect Margie and Dave, and some of it to do other things like build roads. They'll even set aside some of the taxes to help Margie and Dave later on in life when they're retired.

Lesson Summary

To summarize what we've talked about in this lesson: The circular flow model includes households, businesses and governments and shows how money moves around in a simple market economy. The factors of production - land, labor, capital and entrepreneurship - have prices that we call rent, wages and profit. People in households buy goods and services from businesses as well as sell their labor, land and capital in exchange for income. Businesses, on the other hand, sell goods and services to households, earning revenue and generating profits. They also pay wages, interest and profits to households in return for the use of their factors of production. Governments levy taxes on households and businesses in order to provide certain benefits to everyone.

In the circular flow model, injections into the economy include investment, government purchases and exports while leakages include savings, taxes and imports.

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